Today’s financial headlines contain disturbing references to “distressed,” “toxic” or “frozen” assets intended to grab your attention. However, these ominous terms do little to inform the readers about current economic conditions or provide a context for reported financial information.
Current economic conditions aside, the critical context in which the financial performance of any individual enterprise should be assessed is with an understanding of the principles underlying its reported financial results, commonly referred to as Generally Accepted Accounting Principles (GAAP). So what is GAAP and how has it evolved?
Throughout time, the exchange of goods and services in the marketplace has necessitated a financial “language” to communicate the financial activities and position of buyers and sellers. Logically, as is required for any language to flourish, rules and conventions have developed to enhance those communications, similar to the way grammar and syntax enhances written communication.
GAAP consists of these rules and conventions (not a lexicon) for reporting a particular financial transaction or series of transactions. Many of these rules and conventions were developed over time by organizations that were designated to define GAAP, while other rules and conventions were developed as needed by various industries. Largely because of that, GAAP cannot be found in a single reference source.
Today, the Financial Accounting Standards Board (FASB) is the main organization responsible for interpreting GAAP. Its accounting pronouncements provide the rules which issuers of financial statements are to follow for the particular accounting issue they address. The FASB, in recognition that there has been “no one single reference source” for GAAP, is in the final stages of codifying GAAP to a single reference source.
The FASB is a non-governmental body that uses an open decision-making process to develop its pronouncements. This requires it to identify new and existing accounting issues where the reporting conventions being used do not meet the needs of the users of financial statements. After it conducts a study of the identified problem, public deliberations about the issue are conducted and a pronouncement is drafted to address the problem. Requests for comments on the pronouncement are then solicited from the public, another public hearing is conducted and, after additional deliberations, a final pronouncement is issued.
GAAP’s primary purpose is to promote the comparability of financial statements through the consistent treatment of similar transactions, thereby enhancing the flow of commerce, improving the allocation of resources, and hastening the decision-making process.
Consider GAAP as analogous to the rules for driving a vehicle on public roads. While always driving on the right-side of the road is not a universal absolute based upon the laws of physics; it is a choice we have made to ensure consistency among the driving public. Doing so increases safety and improves the flow of traffic. Consider the consequences of one driver careening on public roads in any manner he or she wished; at a minimum it could cause instances of stymied traffic, or worse, a serious or fatal accident.
Investors, creditors, and vendors use financial statements to make decisions. If each set of financial statements were prepared using criteria unique to that issuer, users of financial statements would expend inordinate amounts of time attempting to understand the circumstances of a particular issuer. This additional time would slow the decision-making process to a crawl.
GAAP makes communication more uniform, thereby enhancing decision-making.
We frequently hear the term “toxic assets.” This term refers to assets that are not worth as much as the debt they guarantee. Within the context of GAAP, “toxic assets” are not defined. GAAP, however, does establish rules related to the reported value of an asset.
Consider this scenario: One business places its surplus cash in an FDIC-insured money market account. Another business places its surplus cash in publically traded U.S. Treasury notes. In both cases the cash is required to fund the business’ operations. How does GAAP require the value of the two investments to be determined? The former is valued at the initial investment in the money market fund plus any accrued interest; the latter is valued at the market value of the U.S. Treasury notes. In the latter case, if the value of the note decreases, the business must reduce the reported value and also report the associated loss in value.
Finally, GAAP is constantly evolving in response to the business world—both nationally and internationally. The GAAP of today will not be the GAAP of tomorrow. Ultimately, accounting standards, however defined or established, must benefit the users of the financial information.
Co-written by John D. Blair Sr., a managing partner, and Steven J. Johnston, audit partner, at Blair, Bohlé & Whitsitt, PLLC, a CPA firm that provides accounting, assurance, tax compliance and planning services, in addition to strategic planning and tax minimization strategies to privately held businesses. Contact them at 704-841-9800 or visit www.bbwpllc.com.